Present stock index funds suffer from significant transactions costs because of their need to constantly adjust their holdings of a large number of stocks in order to maintain a portfolio that accurately reflects the performance of the stock index that the fund managers are attempting replicate with their investment fund. In an attempt to reduce these costs, fund managers have developed “tracking portfolios” that contain fewer stocks than the index but have, in the past, tracked the performance of the desired index within certain margins.
The use of tracking portfolios reduces the number of stocks that must be traded, thus reducing transactions costs. However, differences between the tracking portfolio and the specified index may cause the performance of the index fund to deviate somewhat from the index that the fund is seeking to track and the past performance of tracking portfolio relative to the index does not guarantee its future performance. Also, the tracking portfolios still contain large numbers of stocks (although significantly less than the number of stocks in the index) and, as a result, transactions costs remain significant.
Another problem with present index funds, for taxable investors, is the creation of unrealized capital gains that may build up in large amounts before being realized as a result of the transactions required to track the index. Investors in the fund do not know the amount or the timing of the capital gains that may result from the realization of these embedded capital gains as a result of the transactions necessary to track the index. Changes in the makeup of the index (e.g., as a result of merger activity) and/or changes in relative prices of stocks within the index may trigger the realization of large amounts of embedded gains.
In addition to making tax planning difficult for taxable investors, the realization of these embedded gains can create tax liabilities for gains that actually occurred before the investor purchased the fund, thus causing the investor to owe tax on gains that the investor earned. The investor ends up owing tax on “phantom” gains because the investor paid a price for the shares of the fund that included the embedded gains that were realized.
The emergence of deep, liquid markets for futures and options on popular stock indexes has made it possible to develop synthetic index funds that can overcome the problems of high transactions costs, the imperfections of tracking portfolios, the uncertain timing of taxable capital gains and the problem “phantom” capital gains. One of the inventors of the present invention, Anthony F. Herbst, has published academic research (Herbst, Anthony F., and N. Ordway, “Stock Index Futures and the Separability of Returns,” The Journal of Futures Markets, Vol. 4, No. 1, Spring 1984, pp. 87-102) that investigates the performance of stock index futures. This research does not discuss the creation of synthetic index funds but it does provide a foundation for establishing the expected performance of such a fund.
The transactions cost of operating an index fund can be greatly reduced by the use of index futures and/or options in order to create a synthetic index fund. At the same time the accuracy with which the fund tracks the index will be increased because the value of each index future or option is based upon the entire index portfolio, not some “tracking” portfolio whose performance may diverge from the performance of the index.
The use of index futures and/or options can also speed the adjustment of the fund to the index because rebalancing can be accomplished with a single transaction. As a result of the lower cost and greater speed of rebalancing, the frequency of rebalancing can be increased, further increasing the accuracy with which the fund tracks the index. More frequent rebalancing will also mean more frequent trading opportunities for investors who might choose to use investments in the fund as a cost-effective way of carrying out an investment strategy based on timing fluctuations in the index.
As a result of lower operating costs and more accurate tracking of the index, the synthetic index fund will be able to more closely duplicate the investment performance of the underlying index than is possible with a traditional index fund. In addition, the synthetic index fund virtually eliminates the problem of embedded gains, thus improving tax planning for taxable investors and virtually eliminating the problem of taxable investors owing tax on what are phantom gains for the investor.
An additional benefit of the synthetic index fund is that investors will earn a current cash return equal to the interest rate on a selected portfolio of interest-bearing securities (some part of which may be required to be Treasury Bills in order to meet margin requirements) rather than the current dividend yield on the stocks in the index. Because interest rates have generally exceeded dividend yields on stocks in recent decades, the excess of the interest return over the dividend yield on the stocks in the index may make it possible for investors in the synthetic index fund to earn a return greater than the return on the index—with no increase in risk.
In addition to improved investment performance relative to present index funds, the synthetic index fund can be modified to offer investors options that are not available with present index funds. The options which might be offered to an investor, all of which could be efficiently offered by a single fund, include: 1) the choice of multiple kinds of shares involving different stock-related assets and/or different interest-bearing assets, including foreign stock-related assets and/or interest bearing assets; 2) the choice of different kinds of shares offering varying degrees of leverage for the stock-related asset; 3) the option of different kinds of shares that include the option of going short the stock-related asset; 4) the option to switch among various kinds of shares quickly and at a low cost; 5) the option of the investor custom creating his or her own variety of share and varying the nature of this custom share over time; and, 6) the option to invest in one or more varieties of shares managed by professional managers.